There are several factors for dividend policy. These factors range from profit for the current year to an expectation of the shareholders from the company. Let’s discuss different factors that influence on dividend announcement of the company.
Retained earnings
Retained earnings refer to profits accumulated by the company in previous years. These are the profits that the company in the business has reinvested. If the company has not reinvested the retained earnings, free cash must be available on the balance sheet.
So, if the company has higher retained earnings, it’s in a position to pay a higher dividend. On the other hand, if the company is short of retained earnings, its ability to pay a dividend is limited.
Profitability
It’s very simple to understand that a business can pay the dividend if it’s earning profits. If the company is making a loss, it’s difficult to expect from a company that it will pay the dividend. However, if the company decides to pay the dividend despite the loss, it must finance the payment from retained earnings/debt/equity issues.
If the company is able to make payment from retained earnings, it’s well and good. However, if the company needs to opt for the loan to finance the dividend payment, it’s not a good sign of financial conditions.
Type of shareholders
There are two types of shareholders with a perspective on dividend expectations. Some shareholders expect the company to pay the dividend as they need to finance their operating expenses. On the other, some shareholders are large organizations and financial institutions. These shareholders do not expect regular dividends from the company but appreciation in the wealth by increasing the price of the shares.
So, the company needs to consider the clientele of their shareholders before making any decision about dividend payment.
Liquidity
It happens when the company faces issues related to cash flow. Sometimes, the income statement’s bottom shows strong figures, but the company does not have the cash to pay for the material purchases. So, when the company is facing issues related to liquidity, it’s difficult for a company to pay the dividend. Hence, liquidity is one of the most important factors that impact the decision to decide the dividend amount.
Legal constraints
The law monitors issues related to the announcement and payment of the dividend. These laws are mostly directed to protect the debtors of the company. For instance, the company cannot pay the dividend from the capital. This is because debtors of the company stand first in line if the company goes into liquidation and payment is to be made from the capital. This law is known as capital maintenance law.
Several other laws are applicable to the company, including the laws on the Director’s duties, laws of the contract, laws of the sector regulation, and laws of the dividend legislation, etc.
So, it means the company can pay only from the retained earnings, profitability, and debt as well. However, paying dividends from the debt does not signal some good financial conditions of the company.
Life cycle of the business
If the business is in the initial stage of growth, it needs money to finance the different projects. So, they need finance, and it’s difficult for them to pay the dividend. On the other hand, if the business has reached some maturity and got some established operations. It may expect a regular inflow of cash. So, in this case, the business can regularly adopt a stable dividend policy and pay dividends to the shareholders.
Debt seeking ability of the company
Some companies may be able to get debt as they have got sufficient asses in hand. They can give these assets like mortgages and seek financing. On the other hand, if the company has limited assets, it may not be easy for them to get debt on a timely basis.
So, if the company has a higher ability to seek finance, it can obtain finance on a timely basis in case of emergency. Hence, they can afford to pay a dividend because if they are out of cash after paying for the dividend, they can get relief in debt.
However, it’s important to note that the company must formulate some cash budget to assess the extent of dividend they can afford to pay.
Opportunity available for the business
Sometimes, the business has a good amount of cash but no feasible investment opportunity. In such cases, paying dividends seems to be logical because holding extra cash has a high cost.
What feasible investment is?
An investment is feasible if the rate of return on the investment is expected to exceed the cost of capital. Although, a return may be small or large on the gap between expected return and cost of capital. However, both of the investments are considered feasible irrespective of the gap’s volume.
Taxation
It has been observed that some jurisdictions have a higher rate of tax for the dividend income while less tax on the capital gain (earned by sale of the security). So, the companies assess their state of operations and endeavor to maximize return for the shareholders by framing dividend policy in line with the tax mitigation.
